Japanese equities have been out of favour since the country hit an economic brick wall along with the rest of south-east Asia in 1998. It was left saturated by debt, saddled with a vast deficit and struggling to cope with an increasingly wizened demographic and a shrinking workforce.
John MacDougall, lead fund manager on the Baillie Gifford Shin Nippon
investment trust, thinks this perception of Japan is now obsolete.
"The prevailing view on Japan is one which is 10 years out of date," he said. "People still think it has big issues with debt and [industrial] overcapacity, but these were dealt with over a decade ago and companies in Japan are today in a much stronger financial position."
MacDougall also points to valuations in Japan, which he says are at historical lows. The aggressive steps by the government to rebuild the country’s infrastructure after last year’s apocalyptic tsunami are also viewed as positive for the sector, and look set to boost economic growth by as much as 2 per cent this year – very positive for a developed economy at the moment.
The manager thinks small caps are particularly attractive.
"In general there is a bit more scope to find higher growth companies at the smaller end," he said.
"The average age of the management teams I invest in is much younger than the average age for management teams in Japan as a whole. They are much younger, newer companies set up by more dynamic individuals."
"At the larger end, the simple rule of numbers is that a large company with many employees is going to struggle to grow particularly well."
Here are three methods of gaining exposure to the Japanese market for anyone who shares MacDougall’s optimism.
The usual – Unit trusts & OEICs
There are 75 funds in the IMA Japan and Japanese Smaller Companies sectors, so the choice of funds on offer can be somewhat baffling.
Smaller companies funds dominate in Japan. Henderson Horizon Japanese Smaller Companies, M&G Japan Smaller Companies
and Aberdeen Global Japanese Smaller Companies
have all returned in excess of 40 per cent over five years.
Performance of funds over 5-yrs
Source: FE Analytics
The average fund in the sector has returned just 6.39 per cent over the same period, however, and the tail of mediocrity is long.
Well over half the funds in these two sectors have lost money, and the worst offender – Melchior Japan Opportunities – has lost an eye-watering 33 per cent.
Of the winners, Henderson Horizon Japanese Smaller Companies is domiciled in Luxembourg and denominated in dollars, which may discourage some investors. Moreover, the fund is not cheap.
According to FE Analytics
it has a 2.04 per cent TER, with an initial charge of 4 per cent and an annual management charge of 1.5 per cent.
M&G Japan Smaller Companies offers comparable performance with a similar risk profile over five years and is notably cheaper in terms of running costs – with a TER of 1.73 per cent – although it has the same initial and annual charges.
Both funds' managers have added comparable and significant levels of Alpha to their performance, which suggests reliable stockpicking on their part.
A cheaper alternative – Investment trusts
The choice of Japanese investment trusts available is much smaller, with just 10 vying for the top spot, and in terms of historical performance the picture is far less compelling.
The top-performing trust in the AIC Japan Equities sector, Baillie Gifford Japan, is down 4.83 per cent over five years to date, while the best performer in the AIC Japan Smaller Companies sector is up 8.99 per cent over the same period.
Investment trusts are cheaper, though, with no initial charge and only the dealing costs that would normally be paid for an equity. They are also available at a discount and have the ability to gear up using debt, meaning they could be well positioned for a surge in the market.
Narrowing discounts and geared returns could be important for investors who believe managers like Ruffer’s Steve Russell, who fingered Japan as the only developed equity market likely to prosper in the near-term.
The two Baillie Gifford funds are among the most highly regarded trusts investing in this region. Tom Tuite-Dalton, analyst at Oriel Securities, is a fan of Shin Nippon, and also JP Morgan Japanese
IT, which recently saw the appointment of a new fund manager.
"The manager’s performance since his arrival has been ahead of the benchmark," said Tuite-Dalton. "It’s on a 14 per cent discount and that has been narrower in the past; it’s at the wider end of the range at the moment."
Baillie Gifford Shin Nippon was at a discount of 3.5 per cent on August 14, according to data from the AIC, having seen its share price hit a premium earlier in the year.
Prospect Japan is on the widest discount, at almost 17 per cent to NAV, but the trust’s performance over the long-term has been weak – with a lot of risk for relatively little return compared with its rivals.
That has changed dramatically in the last year, however. The trust is the best-performing Japanese investment trust by some distance over that time, returning more than 11 per cent, so further examination of this trust could be worthwhile.
ETFs and trackers
An examination of the top-performing funds and investment trusts in Japan shows those that can demonstrate Alpha lead the pack, so a stock-specific approach pays off – which pretty much rules out ETFs and trackers as a wise choice.
MacDougall explains: "If you are selective and know what you are looking for you can pick up some very attractive opportunities, but I wouldn’t be buying an ETF because there are a lot of low growth and even poorly managed companies out there which might be cheap, but they’re cheap for a reason – and that’s because they’re not going to be growing in the future."
For investors who are unconvinced, the iShares MSCI Japan Index and iShares Japan Small Cap Index ETFs are both established options.